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CHAPTER 12
FISCAL POLICY
WHAT IS THIS CHAPTER ALL ABOUT?
This chapter emphasizes the role played by Aggregate Demand in the market economy, in
particular the Keynesian view of demand and how inadequate demand generates
unemployment. The chapter looks at fiscal policy as an attempt to alter macroeconomic
outcomes.
The chapter focuses of the following questions:
1.
Why did Keynes think the market was inherently unstable?
2.
How can fiscal policy help stabilize the economy?
3.
How will the use of fiscal policy affect the government's budget
deficit?
NEW TO THE EDITION
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New headline on the 2003 child tax credit
New headline on the impact of 2003 tax cuts
New Question for Discussion
New problem on the multiplier
New Living Econ on “How do I create money?”
LECTURE LAUNCHERS
Where should you start?
1.
At the beginning of this chapter, summarize the different tax and budget decisions
currently facing the federal government. Should the capital gains tax be cut? Should
there be only one income tax rate? Does the government spend too much? Too little?
Chapter 12 – Fiscal Policy – Page 240
This summary will generate student interest and provide a solid foundation for the
general discussions of fiscal policy changes in this chapter. It also provides an
opportunity to tie in confidence to the discussion of fiscal policy.
2.
Alternatively, you might use local examples of large layoffs or hirings by some large
employer or the latest unemployment figures for your region. Note that those being laid
off will be eligible to receive unemployment compensation and those being hired are no
longer eligible for unemployment compensation.
This is a good opportunity to talk about automatic stabilizers. Illustrating the potential
fiscal policy implications of these kinds of developments will heighten students' interest
in this material.
3.
Ask the class if the government (local, state, and federal) spends too much money. What
would happen to the economy if they made drastic cuts?
Use this discussion to illustrate how governments use fiscal policy to affect
economic outcomes. This is a nice introduction into the issues of fiscal policy.
4.
Ask the class what they would do with a tax refund check. How much of the refund
would the class spend and how much would they save?
Using their answers, calculate an average MPC for the class. Using this MPC,
go through several stages of the multiplier process to illustrate the multiplier
effect and the tax multiplier.
5.
Bring in a recent news article about tax cuts, tax increases, government spending cuts, or
government spending increases.
This article can illustrate local, state, or federal changes. Although federal
changes are easiest to demonstrate the multiplier effect, the multiplier principle
is the same regardless of who initiates the injection. Discuss how each change
in spending affects the economy. You might want to discuss whether the
changes are targeted for the local, state, or national economy. Use the MPC of
the class to determine multiplier effects. This exercise also offers the
opportunity to discuss leakages from the system. For example, if the spending
or tax injection is from local government, how much of the injection leaks out of
the local economy? How does this affect the multiplier?
6.
Ask the students whether it matters who receives a tax cut or a spending increase?
This question offers the opportunity to discuss the fact that different sectors
have different MPCs. Consequently, the multiplier effect differs depending on
whether spending or tax changes are targeted toward relatively wealthy or
relatively poor sectors of the economy.
7.
Play a multiplier game. Give a student a dollar bill; ask them to "spend" half of it by
cutting or tearing it in half and giving half to another student. Keep repeating. Tally
cumulative spending on the board.
Chapter 12 – Fiscal Policy – Page 241
COMMON STUDENT ERRORS
Students often believe the following statements are true. This same list is included in the
student study guide. The correct answer is explained after the incorrect statement is presented.
1.
Government deficits always lead to inflation. WRONG!
Government deficits may result from government spending to reach full employment
with price stability. RIGHT!
You should focus on what is happening to aggregate supply and demand, not just
deficits, when looking for the sources of inflation. By looking at the deficit, you cannot
tell if there is adequate aggregate demand in the economy. If there is a shortfall in
aggregate demand, government spending and the resulting deficits may restore full
employment with price stability. If there is an excess aggregate demand, demand-pull
inflation can result from increased consumption, investment, or export expenditures,
just as much as from increased government spending. It is all too easy to point the
finger at the government and forget the contribution to inflation from all the other
sectors of the economy.
2.
When a person invests in stocks, investment expenditures are increased. WRONG!
Purchase of stocks has only an indirect relationship to investment expenditure in the
economy. RIGHT!
Investment expenditure refers to purchases of new capital goods (plant, machinery,
etc.) or inventories. A purchase of stock represents a transfer of ownership from one
person to another. Sometimes such purchases are called “financial investments,” but
they do no represent economic investment.
3.
Aggregate demand rises when people buy more imports. WRONG!
Aggregate demand falls when people buy more imports, ceteris paribus. RIGHT!
Students often think of imports as expenditures and therefore believe that increased
spending on imports will have the same effects on the economy as an increase in
consumption. Expenditures on imports, however, do not generate domestic income. If
imports increase, they do so at the expense of purchases of U.S. goods, meaning fewer
jobs in the United States. Because employment declines, there is less income with which
to consume goods; consumption falls and so does aggregate demand.
4.
Macro equilibrium and full employment are always the same. WRONG!
Macro equilibrium and full employment are determined in different ways. RIGHT!
Macro equilibrium occurs where aggregate demand and aggregate supply intersect.
Full employment refers to the use of all available resources in production. If macro
equilibrium does not occur at full employment, there is a GDP gap.
5.
If the government increases spending and taxes by the same amount, there will be no
effect on income. WRONG!
An increase of government spending and taxes by the same amount will expand the
economy. RIGHT!
Chapter 12 – Fiscal Policy – Page 242
The full impact of the increased government spending turns into income for the people
who provide goods and services to the government. Part of the increased taxes,
however, comes from people’s savings, which had been leakages from the economy.
Therefore, consumption decreases by less than the loss of taxes. This in turn means
that income generated by consumption spending is not cut back by the amount of taxes.
Therefore, the economy experiences a smaller cutback in incomes because of increased
taxes than from the stimulus from increased government spending. The net effect is an
increase in income.
HEADLINES
There are three Headline boxes in this chapter. Their titles and the concepts they highlight are:
“Consumer Confidence Plunges to Two-Year Low” (Expectations)
Consumer confidence plunged to its lowest level in two years as the holiday
season failed to lift the spirit of Americans rattled by stock-market volatility and
mounting fears of a significant economic slowdown. Expectations for jobs and
income affect current spending decisions. When expectations diminish, the rate
of spending typically slows down.
“Retailers see results from child tax credit checks” (Fiscal Stimulus)
Rebate checks for the 2003 income tax child credit caused a sudden jump in
retail sales. When 24 million families received checks averaging $583, spending
increased. For example, sales of apparel and furniture jumped 14 percent in one
week.
“Tax cuts could improve growth” (Boosting C, I)
The tax cut package passed in 2003 was expected to increase consumer spending
relatively quickly whereas investment spending was not expected to pick up until
the next year.
ANNOTATED CONTENTS IN DETAIL
I.
Fiscal Policy
Definition: Fiscal Policy - The use of government taxes and spending to alter
macroeconomic outcomes.
II.
Components of Aggregate Demand
A.
Aggregate Demand
Definition: Aggregate Demand - The total quantity of output demanded at
alternative price levels in a given time period, ceteris paribus.
B.
Four major components of aggregate demand. (Figure 12.1)
1.
Consumption
2.
Investment
3.
Government spending
4.
Net exports (exports minus imports)
Chapter 12 – Fiscal Policy – Page 243
C.
Consumption (Figure 12.1)
Definition: Consumption - Expenditure by consumers on final goods and
services.
Note: Consumption expenditures such as tax services, concert tickets, tuition,
sporting event tickets, cars, etc., account for about two-thirds of total
spending in U.S. economy.
D.
Headline: “Consumer Confidence Plunges to Two-Year Low”
(Expectations) Consumer confidence plunged to its lowest level in two years as
the holiday season failed to lift the spirit of Americans rattled by stock-market
volatility and mounting fears of a significant economic slowdown. Expectations
for jobs and income affect current spending decisions. When expectations
diminish, the rate of spending typically slows down.
E.
Investment (Figure 12.1)
Definition: Investment - Expenditures on (production of) new plant and
equipment (capital) in a given time period, plus changes in
business inventories.
Note: Investment expenditures, such as farmers replacing old tractors, factories
installing robotics or new computers, etc., accounts for 15% of U.S.
spending.
F.
Government Spending (Figure 12.1)
1.
Includes federal, state and local spending on highways, schools, police,
national defense and all other goods and services provided by public
sector.
2.
Government expenditures account for 18% of total spending.
3.
Income transfers are not counted because they are counted in
consumption expenditures when recipients spend their payments.
G.
Net exports (Figure 12.1)
Definition: Net Exports - Exports minus imports (X - M)
Note: In 2000 the U.S. bought more goods from abroad than foreigners bought
from U.S.
H.
Equilibrium (Macro) (Figure 12.2)
Definition: Equilibrium - The combination of price level and real output
that is compatible with both aggregate demand and aggregate
supply.
1.
Aggregate demand is not a single number but instead a schedule of
planned purchases.
2.
Inadequate demand and excessive demand
a.
Formula:
AD = C + I + G + (X - M)
Chapter 12 – Fiscal Policy – Page 244
b.
There is no evident reason why AD will always produce
equilibrium at full employment. Sometimes there will be too little
demand and sometimes there will be too much.
III. The Nature of Fiscal Policy
IV.
A.
It would be a minor miracle if C + I + G + (X - M) added up to exactly the right
amount of aggregate demand.
B.
The use of government spending and taxes to adjust aggregate demand is the
essence of fiscal policy. (Figure 12.3)
Fiscal Stimulus
A.
GDP gap
Definition: GDP gap - The difference between full-employment output and
the amount of output demanded at current price levels.
B.
More Government Spending.
1.
Increased government spending is a form of fiscal stimulus.
2.
Definition: Fiscal Stimulus -Tax cuts or spending hikes intended to
increase (shift) aggregate demand.
3.
Multiplier effects (Figure 12.4)
a.
An increase in spending results in increased incomes.
b.
Each dollar is spent and respent several times. As a result, every
dollar has a multiplied impact on aggregate income.
c.
All income is either spent or saved.
d.
Saving
Definition: Saving - Income minus consumption: that part of
disposable income not spent.
4.
Marginal propensity to consume (MPC)
Definition: Marginal Propensity to Consume (MPC) - The
fraction of each additional (marginal) dollar of disposable
income spent on consumption.
5.
Marginal propensity to save (MPS)
Definition: Marginal Propensity to Save (MPS) - The fraction of
each additional (marginal) dollar of disposable income not
spent on consumption; 1 - MPC.
6.
Formula:
MPS = (1 - MPC)
7.
8.
9.
10.
11.
MPC and MPS are decisions that are connected (Figure 12.5)
The fiscal stimulus to aggregate demand includes both the initial increase
in government spending and all subsequent increases in consumer
spending triggered by the government outlays.
Income is spent and respent in the circular flow. (Figure 12.6)
Spending Cycles (Table 12.1)
Multiplier Formula
Chapter 12 – Fiscal Policy – Page 245
a.
Definition: Multiplier - The multiple by which an initial
change in aggregate spending will alter total
expenditure after an infinite number of spending
cycles.
Formula:
Multiplier 
b.
1
1  mpc
The multiplier process at work (Table 12.1)
Formula:
Total change in spending  multiplier  initial change in spending
c.
d.
12.
B.
The circular flow process (Figure 12.6)
Every dollar of fiscal stimulus has multiplied impact on aggregate
demand. (Figure 12.7)
Headline: “Retailers see results from child tax credit checks”
(Fiscal Stimulus)
Rebate checks for the 2003 income tax child credit caused a sudden jump
in retail sales. When 24 million families received checks averaging $583,
spending increased. For example, sales of apparel and furniture jumped
14 percent in one week.
Tax Cuts
1.
Disposable income
Definition: Disposable Income - After-tax income of consumers.
2.
3.
Taxes and consumption
a.
If MPC is greater than zero consumers spend some of the tax cut.
How much of an AD shift we get from a personal tax cut depends
on the MPC.
b.
Formula:
Initial change in consumption = MPC x tax cut (increase)
c.
Formula:
Cumulative change in spending=multiplier x initial change in
consumption
d.
The effect of a tax cut, that increases disposable incomes, is to
stimulate consumer spending.
e.
Cumulative increase in aggregate demand is a multiple of initial
tax cut.
Taxes and investment
a.
Tax cuts for consumers or investors provide alternative to
increased government spending for stimulating aggregate
spending.
b.
President John F. Kennedy in 1963 reduced taxes to stimulate
spending.
Chapter 12 – Fiscal Policy – Page 246
c.
d.
e.
D.
IV.
President Ronald Reagan in 1981 - largest tax cut in history to pull
U.S. economy out of recession.
President Clinton in 1992 promised to cut taxes and increase
government spending to create stimulus.
Headline: “Tax cuts could improve growth” (Boosting C,
I)
The tax cut package passed in 2003 was expected to increase
consumer spending relatively quickly whereas investment
spending was not expected to pick up until the next year.
Inflation Worries
1.
Clinton raised taxes partly because he feared inflationary pressures were
building.
2.
Whenever the aggregate supply curve is upward sloping, an increase in
aggregate demand increases prices as well as output.
Fiscal Restraint (Figure 12.8)
A.
Budget Cuts
1.
Government cutbacks have multiplied effect on aggregate demand.
B.
Multiplier Cycles
1.
Government cutbacks (expansions) have a multiplied effect on aggregate
demand.
2.
Formula:
Cumulative change in spending  multiplier  initial budget change
C.
Tax Hikes
1.
Shift aggregate demand curve to the left.
2.
Tax hikes reduce disposable income and thus a reduction in consumption.
3.
The Equity and Fiscal Responsibility Act of 1982 increased taxes, shifting
the AD leftward and thus reducing inflationary pressures.
4.
President Clinton restrained aggregate demand in 1993 with tax increase,
but increased AD in 1997 with a five-year package of tax cuts.
D.
Fiscal Guidelines (Table 1.2)
1.
The fiscal strategy for attaining the goal of full employment is to shift the
aggregate demand curve.
2.
Fiscal Policy Guidelines
Problem
Solution
Policy Tools
Unemployment
(Recession)
Increase aggregate
demand
Increase government
spending and/or cut taxes
Inflation
Reduce aggregate
demand
Cut government spending
and/or raise taxes
Chapter 12 – Fiscal Policy – Page 247
V.
Policy Perspectives
A.
Unbalanced budgets (Figure 12.9)
1.
The use of the budget to manage aggregate demand implies that the
budget will often be unbalanced.
2.
Budget deficit
a.
Definition: Budget deficit - The amount by which
government expenditures exceed government
revenues in a given time period.
b.
Formula:
Budget deficit  government spending  tax revenues
c.
3.
In 1997, the federal budget deficit was $22 billion. To pay, the
government had to borrow money. By 1992, the deficit had
peaked at $300 billion.
Budget surplus
a.
Definition: Budget surplus - An excess of government
revenues over government expenditures in a given
time period.
b.
By 1998, the deficit had completely vanished and a budget surplus
appeared. This occurred primarily because of an economic
expansion and a stock market boom that swelled tax collections.
c.
4.
budget surplus  tax revenues  government spending
Countercyclical Policy – In the Keynesian view, an unbalanced budget
was perfectly appropriate if macro conditions called for a deficit or a
surplus. Such a policy appears to have been followed by President Bush in
2001 – 2003.
IN-CLASS DEBATE, EXTENDING THE DEBATE, AND
DEBATE PROJECTS
In-class Debate
A Balanced Budget Amendment?
The text describes (on page 290) a proposed amendment to the U.S. Constitution that would
require a balancing the federal budget every year. Should the U.S. pass such a requirement?
1) What are two strong arguments against requiring a balanced Federal budget every year?
2) What are two strong arguments in favor of requiring a balanced Federal budget? (For each
argument you make, you may qualify your support. That is, you may add words to the proposal
to balance the federal budget every year in order to make it acceptable to you.)
Chapter 12 – Fiscal Policy – Page 248
Teaching note
Student answers could consider:
1) a) Balancing the budget could prevent giving stimulus when the economy needed it.
b) Balancing the budget every year could prevent fiscal restraint when the economy needed it.
2) a) It would avoid excessive federal spending by restricting Congressional action.
b) The amendment could be changed to balance the budget over the business cycle or
allow for deficits for certain expenditures or in certain situations.
hands.
to
Extending the Debate
What’s the best fiscal policy?
The text explains the connection between the state of the economy and the appropriate fiscal
policy. If output is too low, below the full employment level, then too-high unemployment is
likely the main problem facing the economy. We should raise government spending or cut
taxes. If output is too high, above the full employment level, then rising inflation is probably the
main economic problem. We should cut government spending or raise taxes.
The text also suggests a connection between the state of the economy and the federal budget.
When output is below full employment, it says a budget deficit is in order. When output is
above full employment, it says we should run a budget deficit.
Use the first web site listed below to find the budget surplus or deficit for the last three years.
Use the second web site to find the unemployment rate during those same years. Explain
whether you think fiscal policy was appropriate during the last three years, assuming the
economy is at the full employment level when the unemployment rate is 5 percent. Make your
reasons clear.
The Congressional Budget Office provides nonpartisan analysis of the economy and the
budget to Congress. Go to their home page (see the URL below), click on “Historical
Budget Data,” and then roll down to look at the last three years of data in Table 1. Write
down the last three numbers in the fourth column, the “on-budget surplus or deficit”.
www.cbo.gov
The Federal Reserve Bank of St. Louis maintains a free database of economic data called
FRED II. Go to the page (find the URL below) and click on “Civilian Unemployment
Rate.” Look at the chart to get the unemployment rate over the last 3 years.”
research.stlouisfed.org/fred2
Chapter 12 – Fiscal Policy – Page 249
Debate Project
Should we abolish the estate tax?
Your estate is what you leave behind for your family or friends when you die. The estate tax is
on the total amount you leave them. The tax rate charged increases with the size of the estate,
just as the tax rates in the personal income tax increase with the amount of income a person
earns. Also like the income tax, some of an estate is excluded from taxation. However, the
exclusion in the case of the estate tax is much larger than for the personal income tax: in 2003
the exclusion was $1 million per person (there’s one complication to this statement, related to
the gift tax, but we will leave that out to keep things understandable). As a result of the large
exclusion, less than 2% of estates pay the tax, whereas about 70% of all families and individuals
pay the income tax.
When President G. W. Bush took office in 2001, he had run on a platform that included the
abolition of the estate tax. The phased elimination of the estate tax was included in the
Economic Security and Recovery Act of 2001, one of the first big pieces of legislation passed
after President Bush took office. A gradual rise in the proportion of an estate excluded from tax
is one way the tax is being phased out. The exclusion was $675,000 in 2001; by 2006 it will be
$2 million. For 2010, the estate tax will be repealed.
However, as things stand (in 2003), this will not be the end of the estate tax. It is scheduled to
be reinstated in 20011! The bill was written in this way to lessen the long-term impact of the
estate tax on the deficit and on the national debt. At the same time, most observers expect that
Congress will find it hard, politically, to reinstate the estate tax once it is repealed. That brings
us to the following questions
Important Questions
1) Is it a good thing for a tax system to be progressive?
2) Is the progressivity of the estate tax an important enough feature of the tax to outweigh any
disadvantages it has?
3) Would reform of the estate tax be preferable to repeal?
4) In order to pay estate taxes, do businesses need to be dismantled with some frequency?
5) Does the estate tax create significant inefficiencies in the US economy, for example by leading
people to elaborate schemes to avoid taxation?
Sources
The Almanac of Policy Issues is a web site providing background information on important
policy issues. The link below is to a sober, brief discussion of the estate tax, its pros and cons. It
is an adaptation of a piece by Jane Gravelle, as tax specialist with the Congressional Research
Service.:
http://www.policyalmanac.org/economic/archive/inheritance_tax.shtml
The American Enterprise Institute for Public Policy research is “dedicated to…strengthening the
foundations of freedom,” including limited government and private enterprise. To find their
work on the estate tax, click on the link below and search their site on “estate tax.”
http://www.aei.org/
Chapter 12 – Fiscal Policy – Page 250
The Brookings Institution supports research and analysis on public policy issues. The first link
below is to their home page. Go there and search on “estate tax” to find publications related to
this project. The second link is a direct link to an article, “The Estate Tax is Down, But Not Out,”
by Leonard Burman and William Gale. The article is a publication of the Tax Policy Center, a
joint enterprise of The Brookings Institution and the Urban Institute.
http://www.brookings.edu/
http://www.taxpolicycenter.org/research/Topic.cfm?PubID=310382
The Center on Budget and Policy Priorities is a respected research organization interested in
fiscal policy and programs that affect the welfare of people with moderate incomes and less. The
link below sends you to their home page. Once there, you can search on “estate tax” to find their
publications relevant to this project.
http://www.cbpp.org/index.html
Citizens for Tax Justice is “a public interest research and advocacy” group, one that focuses on
making the tax system fairer for low and middle-income taxpayers. The link below is to their
home page. Once you are there, search on “estate tax” to find materials they have written.
http://www.ctj.org/
The Heritage Foundation does research and education. Its mission is “to formulate and
promote conservative public policies based on the principles of free enterprise, limited
government, individual freedom, traditional American values.” The first link is to their web site.
Search on the word “estate” to find materials from them. The second link is to a memo
advocating permanent repeal of the estate tax, by William Beach.
http://www.heritage.org/
http://www.heritage.org/Research/Taxes/wm189.cfm
To find out where the President and his team stand on the estate tax, go to the White House web
site and search on “estate tax.” The link below will take you there. The second link is to a
November 2003 statement on the estate tax by Gregory Mankiw, Chair of President Bush’s
Council of Economic Advisors.
http://www.whitehouse.gov/
http://www.whitehouse.gov/cea/NPressClub20031104.html
ANSWERS TO QUESTIONS FOR DISCUSSION, WEB
ACTIVITIES AND PROBLEMS
QUESTIONS FOR DISCUSSION
1.
How long does it take you to spend any income you receive? What happens to the
dollars you spend?
Chapter 12 – Fiscal Policy – Page 251
Expect most students to answer that they spend their money almost as soon as
they get it. You may want to ask them if they use all of their income for
consumption or do they save any. Try to get them to think and talk about the
multiplier effect – that their expenditure turns into someone else’s income,
which that person then uses for consumption, etc. - their combined spending has
on the community in which the college is located.
2.
What is your MPC? Would a welfare recipient and a millionaire have the same MPC?
What determines a person's MPC?
Remember that the MPC is the tendency to consume out of additional income,
not the tendency to consume out of total income. The average student is likely
to have a very high MPC, especially if he or she is the traditional 18-22 year old
student. Lower income people always will be expected to have higher MPCs,
since they need all their income just to pay for basic necessities. If a student or a
welfare recipient were to earn an extra $10,000, they would probably spend
most of it. If a millionaire were to earn an extra $10,000, they may only spend
a small fraction of the extra income. The level of income and tastes are primary
determinants of MPC.
3.
What do people do with that fraction of their income that they save?
From an economist’s viewpoint, they do not invest it. Investment – the
purchasing of capital - is something done by businesses, not individuals. Savers
can hold their savings in a number of ways, ranging from putting it in banks (in
Certificates of Deposit, Passbook Accounts, etc.), buying stocks and mutual
funds, bonds, government savings bonds, gold coins, or stuffing it in a shoe box
and storing it in a closet.
4.
How long does the multiplier process take? How many cycles are likely to occur in a
year's time? How will this alter the impact of fiscal policy?
The answer to this question depends upon how fast consumers actually spend
their money. There are usually two or three rounds of spending each year.
Although mathematically the multiplier process will continue indefinitely, the
majority of the impact of fiscal policy is felt within the first two years. For
example, with an MPC of 0.80, the spending multiplier is equal to 5. The first six
rounds of spending account for nearly 60% of the multiplier process. The next
six rounds account for only 15% of the multiplier process.
5.
Do fiscal-policy makers really need to know the magnitudes of the MPC and multipliers?
Could they get along as well without such information?
Although fiscal policy makers do not need to know the exact value of the MPC,
they need to have good estimates of the multipliers. Failure to understand and
consider that multiplier effect could lead to fiscal policy not meeting its goals by
either not providing enough stimulus in recessions or by ‘overheating’ the
economy resulting in inflationary pressure.
6.
If the guidelines for fiscal policy (Table 12.2) are so simple, why does the economy ever
suffer from unemployment or inflation?
First, there are unanticipated shocks to the economy that can throw it out of the
full employment, stable price equilibrium. Second, there are lags between the
time when unemployment or inflation occurs and when discretionary policy
actually makes an impact on the economy. Third, fiscal policy cannot
Chapter 12 – Fiscal Policy – Page 252
necessarily fine-tune the economy, but can, at best, dampen the business cycle.
Two other key elements to this problem are politics and human behavior. Often,
politicians may have political agendas that differ from the needs of the
economy. Legislation that serves the political needs of constituents may act
counter to recommended fiscal policy guidelines. Finally, not all economists
agree with the foundations on which those guidelines are based on. Different
economic models have been developed which recommend differing policies for
the same circumstances.
7.
Would a constitutional amendment that would require the federal government to
balance its budget (incur no deficits) be desirable? Explain.
From a Keynesian perspective, it would not. The requirement to maintain a
balanced budget would cripple the use of fiscal policy to counteract business
cycles. It would be very difficult to use government spending to stimulate the
economy if taxes also had to be increased to balance the budget. Of course, since
dollar for dollar government spending is more powerful than taxation, then an
increase in government spending, even if matched by an equal increase in taxes,
would be a stimulus to the economy. From a monetarist’s point of view,
restraining activist fiscal policy is a very good reason to require balanced
federal budgets.
8.
In the second quarter of 2003, defense spending surged by 44 percent, or nearly $30
billion. How did this surge affect GDP? Which nondefense industries were most likely
affected?
Defense spending is a category of government spending and is therefore part of
GDP. The nearly $30 billion increase would result in a GDP going up by a
multiple of that spending increase, the exact amount depending on the size of
the multiplier. Every expenditure ultimately translates into someone’s income
increasing and therefore the impact would be felt throughout the economy.
WEB ACTIVITIES
1.
Log on to www.whitehouse.gov/fsbr/output.html. Find data on the current level of
nonresidential fixed investment.
a.
What does the trend suggest is happening to Aggregate Demand?
b.
Draw an AD/AS graph that represents the trend in this data.
The answer to this question will depend on the time period in which you collect the
information. In 2002, the level of output was declining, indicating that AD was falling.
This is represented by a leftward shift of the AD curve.
2.
Log on to www.house.gov/jec and click on the JEC index. Click on "Federal Spending."
In general, how does the JEC suggest the Federal government change fiscal spending?
Why? What will be the likely macroeconomic impact, ceteris paribus, of this change in
spending?
The answer to this question will depend upon the time period in which you access the
information. The macroeconomic impact depends on which school of economic thought
you choose to use to make your prediction. In general, Keynesian’s and supply-siders
believe that fiscal policy can have a positive impact (although they differ as to whether
Chapter 12 – Fiscal Policy – Page 253
we should shift AS or AD) while monetarists believe fiscal policy is ineffective due to the
belief that AS is vertical.
3.
Log on to www.house.gov/jec/bud.htm, then click on the report on budget surpluses
(halfway down the page). Read the report by the Joint economic committee to determine
whether the U.S. government is currently running a surplus or a deficit. What impact
will this surplus (deficit) have on the macroeconomic equilibrium in the U.S.?
The answer to this question will depend upon the time period in which you access the
information. The macroeconomic impact depends on which school of economic thought
you choose to use to make your prediction. A deficit is an injection into the economic
system while a surplus is a leakage out of the economic circular flow. In general,
Keynesian’s and supply-siders believe that these leakages and injections can have an
impact (although they differ as to whether we should shift AS or AD). Monetarists,
however, believe leakages and injections only affect the price level due to the belief that
AS is vertical.
PROBLEMS
1.
If the marginal propensity to save is 0.05, how large is the multiplier? If the marginal
propensity to save doubles to 0.10, what happens to the multiplier?
With an MPS of 0.05, the MPC is 0.95. Since the multiplier is
1/(1-MPC) = 1/MPS = 1/0.05 = 20. If the MPS doubles to 0.10, the multiplier
decreases to 10.
2.
If the MPC were 0.80, how much spending would occur at step 5 in Figure 12.6? How
many spending rounds would occur before consumer spending increased by $200 billion
If the MPC were 0.80, then the multiplier would be 1/(1-MPC) = 1/(1-.8) =
1/.2=5. In step 4 of figure 12.6, households would receive $100 billion in new
income. Of this $100 billion, they will spend 80 percent and save 20 percent. As
a result, they will spend $80 billion dollars in step 5. Consumer spending will
have increased by $195 billion after 4 rounds of spending and by $236 after 5
rounds. These figures do not include the initial $100 billion of government
spending.
3.
a.
b.
c.
The multiplier process depicted in Table 12.1 is based on an MPC of 0.75.
Recompute the first five cycles using an MPC of 0.50.
What is the value of the multiplier in this case?
What is the multiplier when the MPC is (1) 0.80 and (2) 0.90?
(a) Using an MPC of .5, the impact of $100 spent the government will be as follows:
Cycle Change in Spending Cumulative Change
This cycle
1
100
100
2
50
150
3
25
175
4
12.5
187.5
5
6.25
193.75
Chapter 12 – Fiscal Policy – Page 254
(b)
(c)
When the MPC = .5, the Multiplier is 2. = 1/(1-.5)
When the MPC = .8, the Multiplier is 5. = 1/(1-.8)
When the MPC = .9, the Multiplier is 10. = 1/(1-.9)
4.
Suppose the government increases education spending by $20 billion. How much
additional consumption will this increase cause?
Assuming an MPC of .75, the increased government spending of $20 billion will
generate $60 billion in added consumption spending, after the multiplier effect
is fully felt. The multiplier is 4 = 1/(1-.75) so total income goes up $80 billion
from an initial $20 billion fiscal stimulus and consumption increases by 75% of
this amount.
5.
By how much would the 2003 child tax credit increase have shifted AD if the MPC was
0.80. (see Headline p. 285)?
The initial change in consumption = .80 x $14 billion = 11.2 billion
The ultimate shift = $56 billion
6.
If taxes were cut by $1 trillion and the MPC were 0.95, by how much would total
spending:
a.
increase in the first year with two spending cycles?
b.
increase over five year, with two spending cycles per year?
c.
increase over an infinite time period?
Spending
Cycle
1
One year 2
3
Two years 4
5
Three years 6
7
Four years 8
9
Five years 10
Total
Spending
$950 billion
1,852.5 billion
2,709.88 billion
3,524.39 billion
4,298.17 billion
5,033.27 billion
5,731.61 billion
6,395.03 billion
7025.28 billion
7,624 billion
Change in
Spending
$950 billion
902.5 billion
857.38 billion
814.51 billion
773.78 billion
735.1 billion
698.34 billion
663.42 billion
630.25 billion
598.74 billion
Using the table above, a) is $1.86 trillion and b) is $7.62 trillion
c.
Over an infinite time period, the economy would expand by $19 trillion when
the full multiplier effect takes place. This is calculated as:
Tax Multiplier x $1 trillion
= MPC/(1-MPC) x $1 trillion
= 0.95/(1-0.95) x $1 trillion
= 19 x $1 trillion
= $19 trillion
7.
By how much more would the $11 trillion economy grow in the first two years of the
Bush 2003 tax cuts, according to the Headline on p. 287?
The economy was estimated to grow by $27.5 billion in the first year and $55.1
billion in the second year, for a total of $82.6 billion.
Chapter 12 – Fiscal Policy – Page 255
MEDIA EXERCISE
Chapter 12
Fiscal Policy
Name: ___________________
Section: __________________
Grade: ___________________
Find an article that illustrates the multiplier process at work. Use the article you have found to
fulfill the following instructions and questions:
1. Mount a copy (do not cut up newspapers or magazines) of the article on a letter-sized page or
print an article from an Internet news agency such as www.cnn.com, www.msnbc.com,
www.abc.com, www.nytimes.com, etc.
2. What is the cause of the change in income in the economy? Underline not more than one
sentence that describes the cause of a change in income in the economy. Then, below the
article, write what has caused the change in income.
3. Can the cause of the change in income be classified as an injection or a leakage? The change
in income should be caused by a change in a leakage (savings, taxes, or imports) or an
injection (investment, exports, or government expenditure), or in consumption (see
Chapters 9 and 10). Write below the article whether the change in income is due to an
injection or a leakage.
4. Does the change mean there is more or less of the injection or leakage? Write "more" or
"less" below your article, whichever is most appropriate.
5. What group initially experiences the change in income? Use an arrow to point to the single
word or phrase indicating the group whose income has initially increased or decreased.
6. What is the change in spending resulting from the change in income? Circle not more than
one sentence describing the change in spending of those whose income initially has changed.
7. What evidence of secondary changes in income are reported? The changes in spending
should affect the income of others. Place brackets around the one sentence describing this
secondary impact of the initial spending change on the income of others (who were not
affected by the change in number 2 above).
8. In the remaining space below your article, indicate the source (name of newspaper,
magazine or web site), title (newspaper headline, magazine article, or web article
title), date, and page for the article you have chosen. Use this format:
Source: _________________________ Date: _____________ Page: ____________
Title: _____________________________________________________________
If this information also appears in the article itself, circle each item.
9.
Neatness counts.
Chapter 12 – Fiscal Policy – Page 256
Professor's Note
Learning Objective for Media Exercise
To refamiliarize students with the notions of leakages and injections, to show how changes in
leakages and injections have a multiplier effect on the economy, and to recognize such multiplier
effects described in the media.
Suggestions for Correcting Media Exercise
1. Compare the passage that is underlined with the description below the article of whether an
injection or a leakage is involved. Students should be able to identify the change in a leakage
or an injection properly.
2. Check that the indication of "more" or "less" in number 4 is consistent with the leakage or
injection noted in number 3 and with the underlined passage.
3. Check that the circled passage does in fact represent a change in domestic expenditure
caused by the leakage or injection change.
4. Check that the bracketed passage does in fact represent a secondary change in domestic
income from the initial change.
Likely Student Mistakes and Lecture Opportunities
1. This exercise forces the students to look through several articles to find an example of a
secondary impact of a change in aggregate demand. Great sources of information on
multiplying effects can be found in reporting on events such as OPEC oil price changes,
strikes, tax code changes, stock market crashes, currency devaluations, floods, and other
major macroeconomic events.
2. The exercise complements a lecture on the flow of goods and services through the economy.
SUPPLEMENTARY RESOURCES
Eisner, Robert: “The Balanced Budget Crusade,” The Public Interest, Winter 1996. A
lively, thought-provoking argument against mandatory balanced budgets.
Symposium: “Fiscal Policy” The Journal of Economic Perspectives, Summer 2000, pp.
3-74. Accessible discussion of recent research on fiscal policy.
Chapter 12 – Fiscal Policy – Page 257